Written by Andrew Cassar Overend
17 min read
Last Updated on May 13, 2021
You can find a flowchart which can help facilitate your thought process in this section
Equity valuations are at all time highs. Bonds are also in a bubble. Cryptocurrencies have valuations which have no historical backing. Interest rates are at all time lows. Inflation fears are being exposed. And cash is losing value. This is the aftermath barely a year after the pandemic disrupted the global economy. These are odd times for all of us. There are so many moving parts and cross-currents at play that it is a challenging time for the retail investor to think straight. Should you remain invested in these extraordinary times?
We are currently in the middle of the greatest policy experiment of all time. The aggressive increase in the money supply resulting from the joined forces of the Central Banks and Governments have challenged the applicability of traditional asset valuation techniques.
Whether you should remain invested or not is a challenging call to make, but it boils down to an assessment of the possible chain of events, the probability that they will happen and the policy response.
Thus, I present a couple of possible scenarios which can play out which can help us conceptualize what will happen so that we can form an opinion on how to strategize our portfolio. I may be wrong, especially since these are uncharted waters, but I think that understanding the plausible outcomes is nonetheless useful.
Let us look where the global economy was before the pandemic hit. High frequency indicators like the PMIs
These indicators signaled that the 12-year bull run following the Great Financial Crisis was approaching its peak and the global economy was in for a recession. Inflation was also lower. There was excess supply which had to correct downwards to meet the lower demand.
But this time round, a recession
The demand shock was more proliferated than the supply shock, such that disinflationary pressures ensued throughout the first few months of the pandemic (these were deflationary in Europe and Japan).
The unemployment rate skyrocketed in the US, which have less stringent labour laws than other developed economies. In fact, the increase in unemployment in other developed economies was relatively modest, as Governments encouraged part-time work schemes and reassured firms that will subsidize their employees' wages. Following some bureaucratic hurdles, the US Government also heavily intervened, raising record levels of debt to finance its record spending which helped to rapidly reverse the sharpest increase in unemployment in history.
It is ironic how one of the largest recessions in history did not witness a substantial decrease in employment or overall income. In the US and Japan, personal household income never actually fell, while in Europe and the UK the initial decline was quickly recovered thanks to Government support. All this support was indeed necessary and effective in preventing job losses, loan defaults and even social disruption.
Central Banks also resorted to extreme measures, rapidly reducing borrowing costs and supplying economies with astounding amounts of money. To avoid a massive insolvency
However, by intervening to this magnitude, Governments and Central Banks disallowed the business cycle to pursue its natural path and disallowed a well-overdue deleveraging to occur. Thanks to a joint effort to keep otherwise insolvent firms in operation and encouraging employers to hold on to workers, supply was kept artificially high. This meant that firms which would have otherwise become insolvent are still in operation, making unjust use of resources which could have been reallocated and used more productively. And by resorting to relentless money creation and ensuring that it reached the real economy, they hoped that demand will strongly bounce back to meet the supply.
However, since demand is a function of consumer behaviour, the provision of direct monetary support to people may not necessarily translate into higher demand. As examined in my previous article, the money received did indeed boost people's wealth, but what people do with the money determines whether inflation will emanate. Other than spending the stimulus as policymakers intended them to do, the money can be saved, used to pay off debt or invested, so aggregate demand for goods and services may not necessarily increase.
Therefore, thanks to what seems to be a successful vaccine inoculation progress in the developed world, supply bottlenecks are being alleviated, but the demand prospects are questionable.
This brings us to our analysis of what events could unfold in the short to medium term, the policy response which will most likely follow suit, and what investment strategy we should adopt in each case.
Sustained Inflation + Subdued Employment and Economic Growth = Stagflation
The narrative that markets seem to have priced in is that people are fatigued from nearly two years imprisoned in their own home, so demand will bounce back strong. People are assumed to have a bad memory of what happened to them when COVID hit - the risk of losing their job and their incapability of withstanding negative shocks to their financial position - or irresponsibly disregard these facts because they value short term pleasure more. People may also become complacent in their financial management, taking it for granted Governments will step in and send them cheques they are in need.
This will have implication for wages. If the stimulus-fueled demand does indeed come back strong, firms will need to attract workers to work. But if the Government continuously provides income support, workers have no incentive to get back to work. Therefore, firms will have to increase wages. But firms' financial positions are in no state to sustain higher labour costs. This means that profit margins will be squeezed. Firms will be faced with two options:
either absorb the higher costs in their profits, and lower future investment, future wage growth and future employment, which will cause a drag on output growth; or
choose to reflect these higher labour costs into selling prices. This means that goods and services inflation will indeed emerge, but can it be sustained? In this case, people's incomes will get squeezed and demand will eventually fall because prices will be unaffordable.
Under both options, growth cannot be sustained without additional rounds of fiscal stimulus. But if policymakers stick to their commitment to bring employment to their pre-pandemic levels, and thus continue their stimulative efforts in a desperate pledge for people to spend and for firms to invest, then inflation may run hot for some time.
This stagflation scenario implies that while short term interest rates will remain pinned down by the Central Bank (because of the subdued employment and GDP growth), heightened inflation expectations may cause selling pressure on longer duration bonds, causing long term interest rates to increase and the yield curve spread
This may cause some short term panic in the equity market (similar to what was experienced in March/April 2021) because of fears that:
Highly indebted firms will be incapable of servicing their debt
Borrowing costs will increase which will further depress demand for investment and consumer loans
The present value
With higher interest rates for long term borrowing, there will be two effects:
firms and households with longer term debt burdens will face pressure to service the debt at a higher rate
firms and households will reject these higher borrowing costs and will choose not to borrow further. Credit conditions will tighten. And an economy in which credit dries up means that growth will dry up soon after.
To prevent a domino effect of corporate defaults emerging and to prevent credit drying up, the Central Bank is likely to adopt yield curve control
With interest rates pegged and inflationary pressures, there will be downward pressure on real interest rates which can even turn negative. This means that any assets which generate more than a zero yield will be attractive for investors.
Asset valuations are likely to increase and remain at elevated levels and borrowing costs will remain low as long as the Central Bank reassures investors that it will cap long term interest rates.
This means that there will be no reason to sell equities. In fact, there may also be further upside to equities because the limited investment opportunities induce corporations to buy back their shares.
However, even with yield curve control, growth may still remain subdued. Government has two options:
It may issue new debt to pursue further rounds of spending. With yields being fixed by Central Banks, this spending can exacerbate the already prevalent inflation, which can accelerate into hyperinflation. In this case, equities will do well, because more money will be invested into the equity market to get rid of cash and hold assets which have a chance to beat inflation. Besides, although corporate earnings will not grow based on real output due to subdued demand, they will grow because of nominal selling price increases. If a stagflation outcome emerges, traditional hedges of value like gold, silver, real estate and also bets on the future financial system like Bitcoin and other cryptocurrencies will be good to own. Bonds and cash will lose value in this case.
Alternatively, Government can accept the fact that real growth cannot be achieved at such high debt levels and it will adopt austerity policies
Sustained Inflation + Strong Employment and Economic Growth = Reflation
The next scenario is one in which inflationary pressures do indeed emerge accompanied by strong growth. In this case, the Central Bank sees no need to continue accommodating so it decides to taper asset purchases, and provides forward guidance that it will be increasing interest rates in the medium term. Governments will not need to pursue further aggressive fiscal stimulus and can announce a gradual tapering from the end of 2021/start of 2022.
If growth is sufficiently strong that it outweighs inflation, then what we have witnessed following the recession in 2020 was the start of a new business cycle. The demand driven bull market which is already picking up steam in 2021 will accelerate into 2022 and beyond. In this case, risky assets should do well, and the market will most likely sell bonds, causing upward pressure in yields.
But if companies and households foresee pressure to service their debt obligations when borrowing costs eventually rise, they will cut down on their spending in anticipation of higher debt servicing costs and a gloomier outlook for their financial position.
The debt overhang will weigh down the economy once again. Economic activity will slow and inflationary pressures will reverse. There is likely to be downward pressure on risky assets and the spread between corporate and Government bonds should widen. This will eventually cause the Central Bank to reinstate their easing policies and the Government to reconsider fiscal support.
This scenario is essentially a repetition of what happened towards the end of 2018, when the Federal Reserve pursued an overly aggressive tapering policy, causing the overall index to drop by around 20%.
If Central Banks ease sufficiently and debt servicing costs become bearable once again, then another financial asset bull run is most likely. But if growth is unable to regenerate sufficiently, then we may be in for a very short expansionary cycle, which will probably be the last before we reach the end of the long term debt cycle and the entire financial system crashes.
Temporary Inflation + Subdued Employment and Economic Growth = Disinflation
The probability that demand will recover to its pre-pandemic levels is highly dependent on labour market activity rates, namely the number of people in employment and those making themselves available for work. The US FED also made it clear that it will not taper policy support unless it is satisfied with employment progress.
In the US, the participation rate
Even if employment does return to its pre-COVID levels, those who will be re-engaged in the labour market are mainly those in service industries which were mostly impacted by the forced closures, such as the food and accommodation sectors. These blue collar jobs do not pay high levels of income, so betting that spending will surge following the reengagement of these low income earners may be somewhat farfetched.
Besides, some demand will be permanently lost. Businesses will certainly reconsider their need for their office rent and travelling expenses, while the ability for people to work from home will lead to lower spending on transport, food and drink.
Also, those individuals who maintained their jobs and were able to work remotely still had the income to spend on anything they desired. In fact, a notable global surge in demand for goods took place during lockdowns, as people took the opportunity to refurbish their homes and spend on non-recurring consumables like fitness equipment - this means that the pent-up demand narrative which economists are envisaging may not hold.
Even if the pent-up demand narrative does prevail, the demand will most likely be for services which couldn't be enjoyed during the pandemic. This means the outstanding performance of goods in 2020 will face challenges to be sustained towards the end of 2021 and throughout 2022. Instead, assuming the virus subsides, services demand will increase. In this case, while inflation will shift from goods to services, there will be downward pressure on goods prices, so ultimately inflation should remain relatively stable.
This means that by the end of the 2021 or mid-2022 at the least, assuming some degree of normality will prevail, the supply side of the economy will face the ultimate test on how able it will be to sustain itself going forward. This ultimately boils down to the financial position of firms, especially those which were mostly affected by the pandemic and those which have huge debt burdens to service. If firms find that demand is weak, they might have to lay-off workers, or even discontinue operations, causing labour market disruption and downward price pressures.
Also, keep in mind that in 2022, while government support is likely to remain to sustain the subdued growth, there may be a degree of tapering which will act as a drag on growth. This will not be the case for all economies - for instance, the US face mid-term elections in 2022, so I doubt what political sense it means to taper spending. But in other economies, consumption, investment and external demand must outweigh the decline in government expenditure (that is, if tapering ever takes place) for growth to remain positive.
All these factors suggest that the strong growth which will most likely be recorded in the first half of 2021 on the back of policy support will surely be challenging to beat in 2022.
As a result, bond yields are likely to resume their downward trajectory as inflationary concerns are eventually tamed.
Equities will eventually start to show signs of weakness as concerns on the growth outlook are digested by investors and corporate defaults materialize.
Employment and wages fall and hence demand remains weak. This causes further downward pressure on earnings, which do not meet expectations because consumers have lower incomes.
policymakers will observe the deteriorating economic conditions. Central Banks will maintain its easy money policies or even escalate them to reassure the markets of their supportive stance.
Governments will raise more finance to engage in further rounds of stimulus. They are unlikely to impose harsh tax increases on a deteriorating economy (especially since economies like the US face upcoming political elections), meaning that they need to raise finance by issuing debt.
Therefore, bond supply will increase and given the already high debt amounts, this may invoke a temporary break on the declining yields. The money raised from the bond issuance will be disbursed once again into the real economy.
Now with additional monetary easing and further direct stimulus to consumers, further asset price inflation is undeniable as recipients would want to get rid of the depreciating fiat currency and park the stimulus in assets which have more value. Asset purchases will also be propelled by asset managers searching for higher yields other than bonds.
If this narrative prevails, it will make sense to stay invested in equities and equity-like instruments like cryptocurrencies. If people are given the money, they will invest it (or gamble with it may seem more appropriate).
But the stimulus will also reignite inflationary concerns. Complemented with increased issuance, bonds may undergo selling-pressure and rising yields may also weigh down on precious metals.
This means that we are likely to experience a repeat of the events which transpired throughout the end of 2020/first quarter of 2021, with equities making new highs and bonds declining. Therefore, under this scenario, as a by-product of policymakers' intention to revive economic activity, the additional stimulus will continue to inflate assets.
This cycle will repeat itself until investors lose confidence in governments ability to repay the excessive debt and/or people lose confidence in the currency because of the excessive supply of money.
When this happens, there will be blood on the streets. It is hard to prepare a portfolio for this eventuality, but this does not mean that you should exit the markets and sit on the sideline.
Under each scenario, the Central Bank and/or Government are likely to step in to avoid disruption, and this can support risky assets. The insane valuations which currently underpin risky assets are a result of asset price inflation which will continue 1) as long as policymakers remain supportive, and 2) until something breaks and investor exuberance
If the risk of remaining invested is too high for you to stomach, there are better alternatives than holding most of your wealth in cash. Why not try shorting the equities you perceive overvalued using options? Why not buy volatility hedges? You can also cushion any major downturn by geographically diversifying into economies which:
have not witnessed relentless money printing over recent years
have good demographics
have low debt relative to output
have a decent amount of gold reserves at the Central Bank
When a major crash will eventually occur, Government bonds and high grade corporate bonds should hold their value better than equities. Yet this would be an opportunity to invest in equities which would have insane future potential once economic restructuring takes place, especially in view of the digital innovation which will ensure and the new investment opportunities like biotech and green energy. While the cryptocurrency market will probably not be immune from a market crash, it will also be an opportunity to invest in digital concepts with decent value propositions.
The following flowchart can help you evaluate the big picture more clearly:
Note that all scenarios ultimately lead to the inevitable doomsday scenario. Whether this will happen this year or in 10 years time remains to be seen, and that is why I suggest remaining invested, albeit with caution.
Keep in mind that in this analysis, I completely abstracted from certain material events that are worth discounting, such as social or geopolitical tensions which may emanate.
Furthermore, the above scenarios assume that the virus will be a one time episode and that the majority of the global economy will be vaccinated by the end of 2021. If the virus happens to be a recurring event, future growth will be undeniably constrained by mobility, illness and fear and scenario 3 becomes more likely.
Also, this article does not factor in your age and investment horizon, which are crucial elements in investing. So be sure to invest diligently and don't let short term hysteria distract you from your overall thesis.
I truly hope that the above narrative, as well as the previous releases which you can find here and here, will help you formulate an assessment of the potential outcomes ahead. A continuous assessment of the probabilities is imperative, especially those which have to do with the policy response, which are usually exogenous.
And remember, it is never shameful to pivot in your narrative. It will only be a pity if you don't, as your pride may cost you your hard-earned gains.
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